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You can make better choices when it comes to picking independent oil & gas stocks; these five points should help.

Three to five years ago, investing in the American shale boom was pretty easy. You could print out a list of energy companies, pin them to a wall, then throw darts blindfolded, and the companies you landed on would likely trounce the S&P 500. Today, though, it's not as simple, and investors who want to make good decisions in this space will need to do some more digging.

Here's the nice part: Understanding an oil and gas producer isn't that difficult. There are, of course, the financial metrics we all know and love as well as stock valuations, but there are some more specific keys you should consider when looking specifically at independent oil & gas producers. Let's take a deeper dive into this industry to find out how you can make better basic investing decisions in the independent oil & gas space.

Who are we talking about, here?Unlike integrated oil and gas companies, independents exclusively produce oil and gas, That means no downstream assets like refiners or retail arms. In some ways, it makes them much easier to understand, because you don't have to sift through multiple business segments to identify the primary driver of profitability for the company.

The thing is, hundreds of independents are publicly listed on major U.S. exchanges. They can vary in size from having a market capitalization of only a couple million dollars all the way up to ConcoPhillips(NYSE:COP), which today is valued close to $100 billion. Unlike other groups within the energy space like Big Oil and offshore rigs, there are simply too many companies to list them all, or even pick a dozen or so without missing out on some great investing opportunities.

Five key points to considerIn all honesty, there is a bunch of noise that can distract you when trying to identify what is important. So many investors today are worried if companies are in the top shale producing regions, but what good does knowing which shale plays are the best if a company has holdings in a poor part of that formation that barely produces anything? At the same time, there are other companies that don't even operate in shale that can be just as lucrative investments. If you are looking to buy companies on a truly long-term, buy-and-hold strategy, then you need to focus on other keys that are much more important than geography.

To help filter out the noise, here are five key points you should dig into when you are doing your homework. To mention every company would be a little exhausting, so instead -- to give you a little leg up on your research -- I will supply three leaders and three laggards for each of the five points below that have a market capitalizations of more than $500 million.

1. Production potential: Go beyond just proved reservesOne of the major misconceptions about the term "proved reserves" is that many assume its the amount of oil in a reservoir. Actually, it is the amount of oil & gas in that reservoir that a company estimates can be extracted with a reasonable rate of return based on prices set by the Securities and Exchange Commission. This means the total proved reserves for a particular formation can change as prices vary, or if technology makes it cheaper to access that formation. Here is a great visual explanation of this from the U.S. Energy Information Administration.

Source: U.S. Energy Information Admininstration.

To get a better understanding of how much resource potential a company has, it's better to look at what is known as the 3P resources. This means proved, probable, and possible resources. This data gives a little more clarity to how much oil and gas a company can extract if prices were to change, or if technology improves. Not every company provides this information, but if they do, it can be found in its 10-K.

Another thing to consider when looking at reserves -- and production -- is how much of those reserves are in oil, gas, or natural gas liquids. Generally speaking, companies that have higher reserves and production in oil will generally have higher profit margins, because oil has a greater value on the market, but this isn't always the case.

2. Reserves to production ratioThe total amount of oil and gas that a company can access isn't that valuable of information if not taken in context, though. That is where the reserves to production ratio comes into play. The reserves to production ratio is the total amount of reserves a company has on its books divided by its total production, which is typically measured in years.

This is a very crude metric because it assumes two things that are highly unlikely: First, that current proved reserves will remain constant, which also implies that oil and gas prices will remain constant and no new technology will make more oil in place attainable, and second, that production will remain constant over this entire period. Any oil and gas produce worth their salt will look to both increase reserves and production, so the reserve-to-production ratio is only a snapshot of the current situation. If you want to get a little more involved you can do some quick calculations to compare production to 3P reserves or technically recoverable resources as well.

Company

Reserve to Production Ratio

% of Reserves That Are Oil/Liquids

Antero Resources

35.8 years

1%

PDC Energy

29.6 years

41%

Continental Resources

21.8 years

66%

SM Energy

6.7 years

37%

Kosmos Energy

5.9 years

96%

W&T Offshore

5.6 years

56%

Source: S&P Capital IQ, author's calculations.

3. Reserve replacement costsOne important factor to note is that not all reserves are created equal. Certain sources of oil are simply more expensive to access than others, and the ability to access these sources as cheaply as possible can be a major determinant of the future profitability of a producer. We can evaluate this by looking at reserve replacement costs, which is defined as the amount spent on exploration, development, and acquisitions (net of divestitures) divided by the total amount of reserve revisions, extensions, new finds, and acquisitions.

According to the most recent annual survey from Ernst & Young, the average reserve replacement cost in the industry was $20.30 per barrel of oil equivalent. As you can see in the table below, these costs can be heavily influenced by whether a company is bringing on reserves of oil or gas.

Company

Reserve Replacement Costs

% of Reserve Additions That Was Oil/Liquids

Antero Resources

$3.84

0%

Cabot Oil & Gas

$4.56

1%

Range Resources

$4.97

24%

Newfield Exploration

$34.47

100%

Pioneer Natural Resources

$128.19

76%

Encana

$129.28

100%

Source: Ernst & Young.

4. Production costs vs. production mixNot only does a company need to be able to secure its future on the cheap, but investors like us want to find the great operators that are able to produce oil and gas today at a decent price. This is where production costs come into play. Production costs are very similar to operational expenses on an income statement, but without depletion and amortization expenses, since they are a non-cash expense. Most companies will report their production costs on a per barrel of oil equivalent or per thousand cubic feet of gas equivalent for its total production.

Here's the catch when looking at these costs, though: The value for oil is considerably higher than that of natural gas. Looking at a survey of independent oil and gas producers, the production cost per barrel compared to the percentage of production that is oil looks a little something like this:

Therefore, a company that produces a higher amount of oil can be forgiven for having higher production costs, but not too much. So, when you are looking at production costs, be sure to take it into context with the production mix. The companies in the table below are rated and presented based on their production costs per barrel, and the percentage of their production that was liquids.

5. Operational cash flow coverage of capital expendituresThis last metric is becoming more and more important as the shale boom isn't the fresh new thing it once was. Many of the companies in this space have grown production by massive amounts in the past couple of years, but very few have generated the operational cash flow to cover their capital expenses and have been forced to raise capital through debt and equity issuances or through asset sales. According to the U.S. Energy Information Administration, capital expenditures at oil and gas producers currently outpaces operational cash flow by about $110 billion, and that number will likely rise if oil prices remain stagnant.

Source: U.S. Energy Information Administration.

Don't let anyone convince you otherwise -- this is an unsustainable path for companies and should make investors worry about the value of their shares. If this trend continues, companies will be forced to continually issue new debt at higher and higher interest rates, issue value-diluting shares, or be forced to sell off assets that would likely be a part of a longer term future.

For an individual investor, this doesn't have to be the case, because we can pick the companies that are a much more solid footing when it comes to cash generation. This is a very easy thing to look for: Simply look at a company's cash flow -- on an annualized basis to remove any seasonal swings -- and divide that by the company's annual capital expenditures. Any figure greater than 1 is a very good sign, because it is covering all of its expenses with something left over for other needs such as future plans, paying off debt, or even giving a little back to shareholders.

Company

Operational Cash Flow Coverage of Capital Expenditures (%)

Kosmos Energy

169.9%

Legacy Reserves

123.7%

Marathon Oil

118.3%

Diamondback Energy

16.6%

Parsley Energy

8.8%

Magnum Hunter Resources

7.2%

Source: S&P Capital IQ, author's calculations.

What a Fool believesThe oil and gas industry has been a lucrative one for more than a century now, and even though we are making great strides in developing alternative energy, we will likely need oil and gas for decades into the future. Oil and gas producers can be incredibly lucrative investments to play this trend, and having a better understanding of this industry will help you make better stock choices. Looking into these five things won't guarantee you will find the perfect stock for your portfolio, but it should help you separate some of the wheat from the chaff when it comes to independent oil & gas companies. Because unless we see another boom like we have over the past few years, it will take more than a dartboard to make a good investment.